"To go beyond is as wrong as to fall short"
Suffice to say, there will be plenty of winners in The New Reality of proactive investing in 2009. Those who performed during the down move in February and then made the turn here in March/April have huge smiles on their faces this morning. As they should...
Wall Street loves asking "who made money"? And we're fired up to have some of this year's top performers as our clients. I'm already hearing of some fantastic performance starts to Q2 of 2009. As my Partner, Big Alberta Daryl Jones likes to say, "Crush, or be crushed!"
Yesterday was the eve of Obama's speech and month end - these were the two calendar catalysts that we warned the Depressionistas of, and no matter where you go this morning, there they are. We're about to lock in the best month for the SP500 since March of 2000. It will be very interesting to see how all of those Masters of The Quarterly Letter Writing Universe begin to revise their Q1 message to their clients.
Having spent the better part of my career on the buy side at various hedge funds, including my own, this is the way that the communication process works - realize your quarter end numbers in March - take a few weeks to make sure you have the numbers right - then write your accredited investors a revisionist letter that includes some form of an outlook that's based on new numbers (the current month) that you are staring at on your screens...
It's all rather silly really. Generally, there is nothing that's real-time about this quarterly letter writing process; particularly at firms that had a bad quarter. In some cases, disclosure is beyond selective. Selective Disclosure Depressionistas unfortunately cannot put losses on the short side into a "side pocket."
I will be fascinated to read the creativity writings of some hedge fund managers in explaining why they couldn't make money due to the "greatest challenges since the Great Depression" (a bipartisan message fully supported by Washington DC and every CEO in America who didn't do macro), but now can't make money on the long side either. I understand that some will say that "its just a macro short squeeze", but that's about as ridiculous a narrative fallacy as the Depressionista one.
The New Reality is that we are finally flushing out the overcapacity that we had built up in the hedge fund industry. This could be the toothpick industry, and any rational analyst would come to the same conclusion. Too much supply of a commodity ("smart money" with no Street smarts), ultimately results in capacity cuts.
Understanding that this has been a squeeze is one thing. Capitalizing on it is what people being paid 2 and 20 are hired to do. So to the men and women that Squeezy is
chomping on, no more whining and stressing ... or your investors will be giving you a "time out."
Who is winning out there this morning?
1. Obama - the stock market is up +29.1% since March 9th.
2. Obama - the stock market is up +25.3% since he called it a "bargain"
3. Obamerica - the worldwide majority who approves of him leading the USA
That's not a political comment. This is called the political wind. And it's blowing hard Left. As it blows, so will the Arlen Specter's and Stress Testers (see our note titled "The Specter of Arlen" at www.researchedgellc.com). I have been of the mindset that the stock market can actually keep winning if Obama socializes this country to smithereens. That doesn't sound good though, Keith. Good is as bad does folks, so get used to it. As we Break The Buck, stocks will REFLATE.
I know, it's a perverse relationship. And at a bare minimum, it doesn't sound Patriotic - but you know what? Neither do any of these cats you have compromising the integrity of the US Financial System. At the end of the day, its American Idol season, and the world has voted on Timmy Geithner and Kenny Lewis - DOLLAR DOWN!
DOLLAR DOWN = everything else that's asset based UP. Away from Obama lovers, who else is a winner as the Buck Breaks?
1. Americans (value of their 401k and Home stops going down)
2. Russians, Saudis, Canadians, etc... (yes, they like it when petrodollars reflate)
3. US Debt Holders (53% of this world's leverage is denominated in Greenbacks!)
So, as I finish up another of my morning diatribes, please have CNBC remind me that this is nothing but a "short squeeze", and that the 4 months prior was nothing but a "Great Depression." I'll keep on banging out prose with my arthritic hockey knuckles on this key board, reminding you that not everyone in this game needs to play with crutches. Winners will keep winning, and the losers will keep whining.
My immediate term upside target for the SP500 is now 880. I'll be making sales into fire engine chasing strength on the open.
Best of luck out there in May,
EWC - iShares Canada- We want to own what THE client (China) needs, namely commodities, as China builds out its infrastructure. Canada will benefit from commodity reflation, especially as the USD breaks down. We're net positive Harper's leadership, which diverges from Canada's large government recent history, and believe next year's Olympics in resource rich Vancouver should provide a positive catalyst for investors to get long the country.
SPY - SPDR S&P 500-In the face of manic media hysteria, we have once again held onto higher lows. Positive TRADE and TREND.
XLE - SPDR Energy- Energy is breaking out on a TREND and TRADE duration. We're long this sector and think it works higher if the Buck breaks down.
CAF - Morgan Stanley China Fund- A close end fund providing exposure to the Shanghai A share market, we use CAF tactically to ride the wave of returning confidence among domestic Chinese investors fed by the stimulus package. To date the Chinese have shown leadership and a proactive response to the global recession, and now their number one priority is to offset contracting external demand with domestic growth.
EWG - iShares Germany-We bullish German fundamentals, especially as a hedge against financially levered and poorly managed Switzerland. While the automotive industry is ailing, the strength of Germany's labor unions will preserve jobs and maintain a slower rate of sequential acceleration in unemployment. Compared to most of Western Europe, Germany has a positive trade balance and will benefit from Chinese demand, especially if the Euro can stay below $1.32. The ZEW index of investor and analyst expectations for economic activity within six months rose to +13 in April from -3.5 in March, the highest reading since June 2007. We're bullish on Chancellor Merkel's proposed Bad bank plan to clear toxic bank assets and believe the country will benefit from a likely ECB rate cut next month.
EWA - iShares Australia-EWA has a nice dividend yield of 7.54% on the trailing 12-months. With interest rates at 3.00% (further room to stimulate) and a $26.5BN stimulus package in place, plus a commodity based economy with proximity to China's H1 reacceleration, there are a lot of ways to win being long Australia.
TIP - iShares TIPS- The iShares etf, TIP, which is 90% invested in the inflation protected sector of the US Treasury Market currently offers a compelling yield on TTM basis of 5.89%. We believe that future inflation expectations are currently mispriced and that TIPS are a compelling way to own yield on an inflation protected basis, especially in the context of our re-flation thesis.
USO - Oil Fund-We bought more oil on 4/20 after a 9% intraday downward move. We are positive on the commodity from a TREND perspective. With the uptick of volatility in the contango, we're buying the curve with USO rather than the front month contract.
GLD - SPDR Gold-We bought more gold on 4/02. We believe gold will re-assert its bullish TREND as the yellow metal continues to be a hedge against future inflation expectations.
DVY - Dow Jones Select Dividend -We like DVY's high dividend yield of 5.85%.
LQD - iShares Corporate Bonds- Corporate bonds have had a huge move off their 2008 lows and we expect with the eventual rising of interest rates in the back half of 2009 that bonds will give some of that move back. Moody's estimates US corporate bond default rates to climb to 15.1% in 2009, up from a previous 2009 estimate of 10.4%.
SHY - iShares 1-3 Year Treasury Bonds- If you pull up a three year chart of 2-Year Treasuries you'll see the massive macro Trend of interest rates starting to move in the opposite direction. We call this chart the "Queen Mary" and its new-found positive slope means that America's cost of capital will start to go up, implying that access to capital will tighten. Yield is inversely correlated to bond price, so the rising yield is bearish for Treasuries.
EWL - iShares Switzerland - We shorted Switzerland on 4/07 and believe the country offers a good opportunity to get in on the short side of Western Europe, and in particular European financials. Switzerland has nearly run out of room to cut its interest rate and due to the country's reliance on the financial sector is in a favorable trading range. Increasingly Swiss banks are being forced by governments to reveal their customers, thereby reducing the incentive of Switzerland as a tax-free haven.
UUP - U.S. Dollar Index -We believe that the US Dollar is the leading indicator for the US stock market. In the immediate term, what is bad for the US Dollar should be good for the stock market. The Euro is up versus the USD at $1.3297. The USD is up versus the Yen at 97.8020 and down versus the Pound at $1.4846 as of 6am today.
XLP - SPDR Consumer Staples- Consumer Staples was overbought so we shorted more on 4/29. This group is low beta and won't perform like Tech and Basic Materials do on market up days. There is a lot of currency and demand risk embedded in the P&L's of some of the large consumer staple multi-nationals; particularly in Latin America, Europe, and Japan.
"To go beyond is as wrong as to fall short"
Yesterday after the close, MGM announced an agreement with Dubai World and CityCenter's lenders to complete the funding of CityCenter. MGM also announced another amendment to its credit facility. Although neither of these agreements solves MGM's broader credit issues, they do put the CityCenter issue to bed. We continue to view MGM equity as an option and to the extent they can extend the duration of that option, the stock will rise.
Terms of the revised CityCenter agreement:
- Dubai World and MGM will fund their remaining equity contributions through letters of credit
- CityCenter's lenders will immediately fund the full $1.8BN facility
- Dubai World was relieved of all completion guarantees in return for paying $135MM of contribution made by MGM on its behalf and dropped its suit against MGM
- MGM is now solely responsible for the completion guarantee of up to $1.2BN should the construction budget exceed $8.5BN and net condo proceeds fall below $243MM
- Interest rate margin increased by 200bps, though payment are "PIK" (paid in kind) through 9/2010
- Condo proceeds up to $250MM may be used towards construction costs; 30% of net proceeds in excess of $250MM will go towards debt reduction, while the remaining 70% will be distributable subject to certain performance criteria satisfaction
- Certain financial covenants were also loosened
- Facility matures June 30, 2012
Essentially MGM's only incremental cost for this amendment was the guarantee and $18MM in incremental annual interest ($36MM for the JV). According to its 10K, MGM estimated it would need to fund $319MM of its $600MM guarantee, translating to $638MM without Dubai World's share. However according to our math, MGM will likely not have to fund any of the guarantee. MGM's estimated total construction budget was $8.7BN on its last conference call. Management also believed that they could save an incremental $200MM of costs, bringing the total cost pre-condo sales to $8.5BN. In addition, MGM had $1.6BN of contracted condo sales of which they estimated 75% would close, bringing the net cost comfortably below their completion guarantee trigger.
MGM also announced another amendment to its credit facility:
- Additional 45 day waiver of its covenants through June 30, 2009
- Allows MGM to make its remaining equity contributions to CityCenter through the issuance of a $224MM letter of credit
- Permitted MGM to enter into revised CityCenter completion guarantees
In return for this amendment MGM:
- Reduced borrowings and commitments under the facility by $100MM
- Provided the banks additional collateral: Gold Strike Tunica, MGM Grand Detroit, certain undeveloped land on the Las Vegas Strip, and to secure debt under the facility in an amount up to $300 million
Interestingly, this additional collateral does not count against MGM's ability to secure an additional $1.7BN from its $3BN basket. The bank agreement permits granting security in assets that fall under a certain threshold (2% of net tangible assets) and MGM Detroit is also carved out in its credit agreement.
We believe the next steps for MGM will involve some combination of the following:
- Exchange offer for the 6% Senior Notes due Oct 2009 ($820.9MM O/S as of 12/31/2008)
- Exchange offer the 9.375% and 8.5% notes due in 2010 (Approx $1BN)
- Sale of Beau Rivage and/or MGM Detroit
- Equity raise ($500MMish...)
- Secured note issuance
- Pledge of additional collateral to banks in exchange for covenant relief and additional waivers
We expect the stock to open higher as MGM has extended the duration of its equity option.
Japanese industrial output for March was a sequential improvement
Japanese equities rallied on the back of the broad US rally and March Industrial Output data, which came in well above economist estimates at a 1.6% improvement over February -the first sequential monthly improvement in 6 months. The chart below illustrates the same data on an absolute and year-over-year basis, which paints a decidedly less enthusiastically bullish picture.
Clearly output improved on the margin, just as slamming into the canyon floor is finding a bottom -but our thesis on Japan remain s eth same. The anemic stimulus package that Aso's government has formulated will not be enough to offset external demand, and waiting for US consumer demand to return (or Chinese consumer demand to develop) for exports like high-end automotive will take a good while. Still, Aso's trade mission to Shanghai today reflects Japan's commitment to working with the Client, and every indication is that Chinese appetite for heavy equipment is surging, a massive positive for heavy industrials. Clearly the glass-half-full crowd will find reason enough to be positive.
Tactically, Keith covered our EWJ short heading into last night's data (excellent trade on his part) and we will look to re-short higher in the near term unless the Yen declines and provides exporters with greater breathing room or the broad economic data provides more significant bullish signals.
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The anti-SBUX commentary will fall into two buckets (1) in 2Q09 same-store sales trends declined 8% and on 2-years basis sales trends continues to decline and (2) McDonald's move into the premium coffee segment is going to hurt SBUX when they go on national TV. Importantly, Starbucks proved this quarter that there are significant costs the company can cut to help stabilize margins. It will be hard for any anti-SBUX commentary to say "even with the cost cutting the company can't make the numbers."
MARGINS ARE IMPROVING
I don't care how negative people are the Starbuck's, the core of the business model is very healthy and is showing very sustainable trends that that was not there three to six months ago. For the past two quarters the company has posted sequential improvements in operating margins, and will report year-over-year improvement in 3Q and 4Q of 2009. This is directly attributable to the progress SBUX has made on its cost cutting initiatives. In 2Q09, SBUX delivered $120 million in cost savings, exceeding the $100 million target. For the balance of the fiscal 2009, SBUX has cost savings of approximately $150 million in 3Q09 and $175 million in 4Q09.
On a consolidated basis (excluding restructuring charges), 2Q09 operating margin was 8.3% versus 8.4% last year. Operating margin in Q2 improved sequentially by 20 basis points from 1Q09. In the U.S. operating margin for 2Q09 was 10.9% versus 11.5% last year (excluding restructuring charges) and internationally 2Q09 operating margins were 4.8% versus 5.1% last year.
A very powerful trend in margins!
TRANSACTIONS REMAIN ELUSIVE
The Starbucks critics will be loud and clear that the top line trends are weak and getting weaker. Admittedly, the top line trends remain an issue for the company, but I contend that it's not terminal and many people overstate the impact McDonald's will have on the business. Don't get me wrong; the issues Starbucks faces are far from trivial and McDonald's is a great competitor, but to think that Starbucks is not fixable is crazy. There are a lot of high-end retailers that are not doing well today, but the Starbucks basic drip coffee is anything but expensive at around $1.65 for a 12oz cup.
In order to sustain continued stock price appreciation, SBUX cannot rely on cost saving initiatives alone, but the company has bought themselves some time. Investors will expect to see a turnaround in sales to solidify the turnaround. While comparisons do get significantly easier as we move into 2H09, the company finally announced last night that it will launch a multi-million dollar advertising campaign focused on the quality, value and the values that Starbucks offers. The timing of the Starbucks advertising campaign will pre-empt the national launch of McDonald's premium coffee. Given the cost of media today, it's a great time for Starbucks to be launching a national advertising campaign.
Also, beginning May 5th Starbucks will offer a Grande iced coffee for less than $2. This is an important step to extend value to the Starbucks customers in an attempt to build transactions. Lastly, the company will fine tune its menu prices in several key markets to better align geographic COGS and labor issues. This will result in minor changes to prices, that that will lower prices on some of our more popular items such as tall lattes and slightly increase prices on larger and more labor intensive beverages.
The rate of decline in Starbucks same-store sales is slowing!
In 2Q09 SBUX reduced our short-term borrowings from $290 million to $226 million and does not need to seek an amendment to their credit facility. The potential amendment was driven by the lease termination costs associated with the decision to close another 300 underperforming stores. Starbucks said last night that the impact from lease exit costs for the balance of fiscal 2009 will be lower than previously expected, thus they are no longer pursuing the necessary amendment.
Capital expenditures for the first six months were $237, down from the $505 million in capital spending last years. In 1H09 SBUX generated $715 million in cash from operations and $479 million in free cash flow.
With the stock up nearly 45% this year valuation has improved, but the sentiment on the stock has not. As top line momentum begins to improve the flow-thru to EPS will be even greater, given the new cost structure of the company. At current levels and no change in estimates there is 11-23% upside to the stock.
We've been negative on this one for a while, though admittedly wish we were louder into this earnings report. Anyone who thinks that a global company with a portfolio of core cash flow generators layered with younger growth brands could escape the worldwide recession is out to lunch. Now it's time for VFC to play catch up with the rest of their apparel brethren and take their lumps on margins while aggressively cutting inventories.
The Street has cut numbers substantially for the next quarter, but the full year appears to be settling out in the middle of management's provided range of $4.70 to $5.00. We think these numbers are still too high. We're getting to something closer to $4.50. The inventory clearing process (while ultimately positive for FCF) will hurt gross margins big time over the next couple of quarters. With 50% of the problem lying in the European denim business, we think it will take some time to work through the inventory. Last time we checked there weren't many major off-pricer's in Eastern Europe or Scandinavia. Admittedly, 4Q is still a toss-up at this point given the easy margin and topline compares that resulted from the most volatile shopping season on record - but we don't have the confidence that management can proactively drive the entire portfolio this far out when it has so much on its plate.
However, a couple of points are clear to us:
Inventories are coming down (-4% in Q1, should be -10% for the year) but it will take some time to get to manageable levels. Along the way, there will be gross margin pressure that likely persists throughout the remainder of the year. It does not take much GM% erosion to get to management's guidance. But forced inventory reduction could easily take out an extra point or two. Remember, VFC has been an apparel conglomerate for a number of years disguised as a growth company. Meaningful inventory reductions have not been part of the equation here for a long time.
Newer brands are finally showing signs of weakness as evidenced by a decline in 7 For All Mankind, negative sales in the outdoor segment, and negative mid single- digit comps in the newly-built retail operation.
Cost savings remains on track, but even cutting $100mm this year cannot offset leverage loss on the top line. This is not the kind of company where it pays to cut costs in a meaningful way. Portfolios of retail past (the JNY's and LIZ's of the world) virtually destroyed their respective businesses by cutting too much muscle.
While not the biggest takeaway from the quarter, we found it interesting that 7 For All Mankind reported sales declines, even with new store growth helping to grow the topline. We're not sure if it makes sense to continue to roll out high cost retail flagships when customers don't seem as interested these days in $200+ denim. We realize the brand is still evolving but it's never a great sign when a growth vehicle stops growing. Unfortunately, the success of The North Face is extremely difficult to replicate...
We wonder how quickly VFC can layer on acquisitions to offset the focus and reality of slowing core brands and maturing young brands? Is the long rumored DC shoe deal going to re-emerge? It better... (and at a fire-sale price).
We wrote about the potential for a big quarter in our note "ASCA: INCENTIVE TO BLOW OUT Q1". However, the quarter was even better than our most optimistic scenario. Property EBITDA beat us at every property and increased YoY at every property, save East Chicago. Competing with Harrah's used to be a tough business. All together, corporate EBITDA increased 21%. We're in a recession?
Margins were the story as revenues were just flattish. Certainly, ASCA had an incentive to beat the quarter, as we discussed in the 4/12/09 note. ASCA will be in the market to raise subordinated debt or extend the maturity of its credit facility. The current credit facility expires in November of 2010. Our thesis was that the credit markets needed to be pried open and a big quarter would be a good start. Regional gaming credits trade at a big spread to other similarly leveraged consumer sectors because they are, well, gaming. MGM, Station, Harrah's, etc. continue to weigh on the sector. The "collusion" of strong regional gaming earnings releases (ASCA, PENN, PNK) could change that.
ASCA closed up 21% on the day, and rightfully so. We are now projecting EPS and EBITDA of $1.48 and $379 million, respectively, for 2010. We took a hack at EV/EBITDA as a valuation tool (4/20/09 - "GAMING REGIONALS: THE FALLACY OF EV/EBITDA") since it doesn't incorporate refinancing risk or increasing cost of debt for companies with nearer term debt maturity or covenant issues. For ASCA we've incorporated the incremental borrowing costs of a refinancing into our 2010 estimate so we will look at both EV/EBITDA and FCF yield for the stock.
After the big move in the stock and a significant hike in our EBITDA and FCF estimates, the stock looks like it is valued pretty close to perfection. EV/EBITDA and FCF yield on our 2010 projections is 6.6x and 14%, respectively. In the 4/20/09 note we pegged fair value at 6.9x and 15%, respectively. Multiples could go higher and we are open to debate, but we'll sit tight for now.
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